Asia Pacific: The Chinese Decade
Andy Xie (Hong Kong)
morganstanley.com
China’s role in this decade is similar to what IT’s was in the 1990s, in my view. The country changes relative factor prices and, therefore, triggers economic realignment. IT dramatically decreased the cost of information and depressed the value of information-intensive products relative to others. Financial services and information providers are still living through its consequences.
China reduces the prices for labor and capital, but unlike IT, labor and capital don’t travel well in the global economy. The equalization process for these factor prices between China and the developed economies works through the trade of manufacturing products. Although IT’s impact was mainly to change the income distribution among sectors, China changes income distribution among both sectors and countries.
Morgan Stanley was the host of a MacroVision workshop last week for global investors to work with Morgan Stanley’s macro team to identify cutting-edge macro themes and their possible investment implications. China’s role featured prominently in most scenarios. In the post-IT world, the financial community is looking for the next big idea. China increasingly looks to be it, and in my view, it certainly should be.
Like IT, the financial community will form its own hype, fears and bubbles about China for years to come. The most productive approach, in my view, is to form the right model about China’s role in the world and select investment opportunities accordingly. Indeed, there will likely be many great opportunities to take advantage of the market’s excessive fears or hype about China. If life sciences don’t mature to create another bull market based on technology in the next decade, China’s dominant influence in the global economy could remain for an extra decade.
Factor price equalization is the best starting point to picture China’s interaction with the global economy, in my view. Why should it matter? After all, didn’t Japan and the Tiger economies develop through the same process –factor price equalization with mature economies through trade? The difference is China’s size and its development speed. Other East Asian economies changed relative prices somewhat during their development process and didn’t leave lasting effects on relative factor prices once they matured because they were quite small relative to the developed world and are still relatively small even in their maturity.
China’s labor force is bigger than that in all of the OECD countries combined. Its rapid development has caused dramatic shifts in relative factor prices in a short period of time. Some of the changes will be permanent even with China’s maturity. The most important one is that the value of labor will be permanently devalued against scarce resources. This is likely to have far-reaching consequences to the distribution of income in the world.
The speed comes from the fact that the labor productivity gap between China and the mature economies is far less than the wealth gap between them. In the past century, China fully participated in the global economy for a total of only 35 years. It successfully integrated into the global economy in the 1920s and 1930s, managing to grow its economy at 5%-plus through the Great Depression. After the Japanese invasion interrupted the process, China went on a different path. China only began to again integrate meaningfully into the global economy in the mid-1980s.
Labor productivity is a combination of learning-by-doing and education. The former needs investment and the later doesn’t. Labor productivity in developing economies comes mostly from generational shifts, in my view. Indeed, the saying that “you can’t teach an old dog new tricks” appears to have some merit of truth. Therefore, labor productivity is mostly about the quality of education and childhood environment. Apart from the decade of the Cultural Revolution, China maintained a focus on education during its turbulent periods, which allowed its labor productivity to grow even though household wealth didn’t.
China’s reintegration into the global economy, therefore, presents a major discontinuity. The gaps between China and developed economies for productivity and for wealth are expressing themselves through rapid capital reallocation from mature economies to China and the consequent rapid growth of China’s exports. The key driver is China’s low wages resulting from its vast surplus labor and low level of wealth. These are two sides of the same coin – if China’s wealth had kept up with productivity, China’s labor force wouldn’t be so underemployed in the first place.
There is a serious misunderstanding about China’s currency value, in my view. An increasing number of opinion makers appear to believe that China’s competitiveness comes from its deliberate policy to undervalue its currency and, therefore, boost its export competitiveness. However, a currency’s value matters only if domestic prices are rigid – a major appreciation of a currency can’t be offset by a decline in domestic prices especially when debt values can’t change in nominal terms. This doesn’t hold true for China; its labor market is totally flexible. Indeed, prices of goods and services are declining in general. If China were to appreciate its currency, it would naturally worsen deflation, which would restore competitiveness over time, and the balance sheet constraints will be solved with more bad debts.
There are five major factors in production that can be priced distinctly: intellectual property (IP), labor, capital, land and natural resources. China’s story for natural resource isn’t ambiguous. China’s households have low wealth levels and spend their income disproportionately on housing, food or buying automobiles for the first time. China’s household spending is much more commodity-intensive compared with how marginal income is spent in mature economies. When China’s economy matures, its commodity consumption might decelerate but won’t decline. Therefore, China’s development is unambiguously a bullish story for commodities.
At our MacroVision workshop, a number of investors pointed out South Africa and Australia as big winners. I would also bring in Indonesia as a major beneficiary. Malaysia and Thailand will likely also be positively affected by China’s development in that regard. I am not arguing that the recent run-up in commodity prices is all due to China. The trade cycle probably played a more important role (see “China Economics: Is Inflation Back” of January 17, 2003). The cyclical outlook for commodities is in fact negative for the next two quarters; however, the long-term story is undoubtedly bullish for commodities.
In addition to this general demand story, one must bring timing and supply into the picture. Certain commodities take off only when China’s per-capita income hits a particular point. For example, when a large number of Chinese could afford to purchase flats, steel demand took off. Foodstuffs are a rolling story. Palm oil and pistachios are there, but wine and cheese are not yet but prices for these goods will likely take off at some point in this decade.
However, China’s own supply capacity should remain a constraint on commodity price inflation. Anything that is about capital and labor will have a hard time maintaining high prices. Sooner or later, China will produce enough a good for itself and export some. Semiconductors are a great example. Chips are now on China’s chopping block, which means they will not likely be highly profitable in the next upturn. Investors who look only in the rearview mirror will be badly hurt, in my view.
On the other extreme, China is clearly a deflationary force for labor. Wages for low-skilled workers are under pressure. As China’s education improvements progress and its manufacturing base becomes more sophisticated, wages for skilled workers globally will also come under threat. Many would argue that some sectors are not tradable and, therefore, should be immune. This is an erroneous assumption, in my view. As college graduates in mature economics shift into these non-tradable sectors because of the higher wages, wages for those non-tradable sectors will likely come under pressure as well.
When we talk about wage levels, what should serve as anchors? There are two possible anchors: land and commodity prices. One or both should work, in my view. In countries with ample supplies of land, commodity prices become the critical factor for the real wage values; meanwhile in economies with limited land supplies, housing costs will determine real wages. A portion of the increase in property prices globally in the past two years reflect this dynamic, in my view.
Intellectual property in theory should be the biggest winner. China’s development means a bigger market for something with zero reproduction cost. The real story is, of course, more complicated. IP rights for mass consumer market products might not benefit their owners initially. China’s income level is too low for IP owners to price IP goods at affordable prices for China’s consumers. Otherwise, it would cut their revenue too much in developed markets. When China’s consumers become rich enough, IP providers should be able to integrate China into their pricing strategy and benefit as a result.
However, the situation in the business sector is much better. The enforcement of IP rights by China’s government is clearly having an impact on the revenue of IP providers in China. For example, companies in China have become big enough now that they don’t want to risk their overall businesses for the small savings of using pirated software. They are also trying to use licensed technologies as a competitive advantage and, therefore, are becoming vigilante in defending IP rights as a result.
Even on IP, I believe one must take into account China’s supply capacity. IP based on production processes can easily be duplicated without violating patents. The traditional manufacturing powerhouses tend to count on such IP and might not benefit much from China’s development at all. Whereas IP that is rooted in standards, brands or fundamental science should benefit greatly from China’s development.
China’s most important impact on financial markets globally is likely to perhaps be on inflation. It is quite popular to argue that deflation is just a monetary phenomenon. However, when relative prices are changing fast, monetary policy may not be and, indeed, shouldn’t try to keep prices rising for a product category. For example, if a monetary authority tries to keep manufactured goods prices increasing, it may simply translate into more imports without much effect on price. The right monetary policy should target positive GDP deflator only, in my view.
The equilibrium inflation rate in the global economy will likely remain quite low at least in this decade. Therefore, the decline in sovereign bond yields should be viewed as permanent. This disinflationary impact on credit quality is the opposite. Diminishing pricing power in general increases the credit risk associated with business operations. Therefore, corporate paper should be treated cautiously.
Will low inflation rates turn into outright deflation? It really depends on fiscal policy. As capacity formation shifts to China, mature economies will suffer structural shifts in savings rates. Low interest rates might encourage household demand for capital through property purchases for a while but aren’t likely to do much for business demand for capital. Savings rates don’t really respond to interest rates. Therefore, sustained and large fiscal deficits are the only instrument to keep deflation at bay. I believe that the US and, soon, Europe will embark on this trend. The world could avoid deflation.
Finally, how would the income spillover from China benefit other economies? Tourism is a good example. Its beneficial effects depend on a country’s income gap with China. Malaysia and Thailand, for example, are likely to benefit substantially from increased Chinese tourism. Their per-capita income is similar to China’s and Chinese tourism can create jobs in their economies at the prevailing wage levels. However, increased Chinese tourism would likely be much less of a benefit for Hong Kong or Singapore. People who like to dress in Armani can’t make a good living by serving people who shop in Giordano.
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